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August 21, 2006

Data Dependent

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

“A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth.”

- Warren Buffett

One of the perspectives that I often find useful is to view market fluctuations as the gradual adoption, playing-out, and abandonment of various “themes” or “concepts.”

Sometimes these themes are valid and conceptually reasonable. For example, once the market has experienced deep losses, valuations are cheap, interest rates are falling, earnings are disappointing, a recession is well-recognized, and conditions are expected to worsen, it's not unusual to observe a high-volume lopsided-breadth reversal to the upside. At that point, investors have seen enough false rallies to hold out any hope. But depending on the quality of market internals, that sort of abrupt shift in “sponsorship” is often a good indication that the underlying “theme” of the market has changed for the better, and that the market sees legitimate potential for the economy to improve. While valuations never got particularly “cheap” during the 2000-2003 bear market, that sort of shift in sponsorship was the reason we lifted 70% of our hedges in the Strategic Growth Fund early in 2003.

Other times, the “theme” of the market is neither valid nor conceptually reasonable. The dot-com bubble was one example, where the basic economics of free entry ensured that growth in the internet would not easily translate into explosive profits for every dot-com floating an IPO. Eventually, the dot-com's crashed, but the theme continued to what I called the “dot-nets” – companies that helped to form the backbone of the internet, such as Cisco, Sun Microsystems, and EMC. Unfortunately, that theme also went far beyond reason, and crashed as well.

At present, the market is struggling between two different themes. On one hand is the notion that the economy is slowing, that inflation will slow with it, but that corporate earnings will remain strong, prompting some analysts to dredge up the word “Goldilocks” (If I ever use this, or the phrase “sweet spot”, in a description of the economy, please, somebody slap me). On the other hand is the notion, which I continue to argue, that the economy is likely to slow, but that (barring default problems and widening credit spreads) inflation will remain persistent and structural.

Given this debate, we've got to allow for the possibility that investors will grab onto one theme or another, or even bounce between them, until the evidence becomes decisive.

Buffett's remark about Wall Street getting “a concept in its teeth” is important, because it means that we can't simply ignore or trade against the market's various “themes” or concepts just because we believe they're wrong. When a concept is widely believed by investors, they may not abandon it immediately, so it's important to gauge the amount of “sponsorship” they throw behind it.

That broad analysis of investor sponsorship and the broad quality of market internals goes into what I refer more concisely as “market action.” Historically, when the broad internal quality of market action has been favorable, valuations have tended not to matter much in the short-term, and the market has been able to advance even on concepts that ultimately proved incorrect (like the perception that the dot-coms and dot-nets would move relentlessly higher).

In contrast, when market action has been unfavorable (again, in terms of measures of price/volume sponsorship, market internals, broad industry action, divergences, and other factors above and beyond simply the behavior of the major indices), market advances based on optimistic concepts have generally not worked out well, and have often ended abruptly, particularly when valuations have been rich.

So for example, if valuations are depressed and market action has turned favorable, it's dangerous and stubborn to stick to a defensive or bearish investment position, even if it seems that the economy is likely to worsen. The favorable behavior of market action in that case suggests that positive surprises are more likely than not, and depressed valuations allow for a good deal of upside potential for the market.

Likewise, if valuations are rich and market action is unfavorable, it's dangerous and stubborn to stick to an aggressively bullish investment position, even if it seems that the economy is likely to improve. The unfavorable behavior of market action in that case suggests that negative surprises are more likely than not, and elevated valuations allow for a good deal of downside potential for the market.

We always defer to the condition of valuations and market action in setting our investment position. These take precedence over which direction the market or economy “seems” to be headed, or whether the news seems likely to get worse or better.

In short, we're “data dependent,” to use Bernanke's phrase. But the important data is about valuations, investor sponsorship, market internals, and so forth – not on every word and inflection of the Federal Reserve, and certainly not on every pip in noisy monthly inflation data. Ultimately, the best long-term results combine a respect both for valuations and for market action. For now, that evidence holds us to a defensive investment stance.

A Turn in Inflation?

The markets took heart last week in a modest decline in the Producer Price Index, as well as a core CPI inflation rate that came in a pip (0.2% versus expectations of 0.3%) below expectations. The market reacted with the same delight as a starving man finding a hamburger. No matter that the burger was in the middle of the street and had just been run over by a truck. The market was starved for good news, and at least this was something.

Despite the market's reaction, the hope that inflation is slowing is hardly supported by the data. The “great news” on the CPI wasn't even outside the bounds of rounding error, while the PPI figures were actually of significant concern. Sure, the prices of some volatile items like eggs and fish fell steeply, but the improvement in the PPI for “finished goods” was overshadowed by continued pressure in the PPI for “intermediate goods.” Here's the picture that concerns me.

Over the past year, consumer price inflation has clocked in at 4.15%. Producer price inflation (finished goods) has been a similar 4.12%. But if you look at intermediate goods, we're currently at an inflation rate of 8.83%. That's the most abrupt widening in the spread between intermediate and finished goods since the 1973-74 oil crisis. Moreover, if we look at points in history when prices for intermediate goods have outpaced prices for finished goods over a 6-month period, we've also seen, on average, an acceleration in the PPI finished goods inflation rate over the following 6 months.

So if there is credible evidence to be found of weakening inflation pressures, it wasn't to be found in last week's CPI or PPI reports. About the best that can be said is that lower interest rates might take monetary velocity down a notch, but given that those lower rates were probably largely an overreaction, any favorable implications for inflation also require those lower rates to stick. At this point, both stocks and bonds are overbought, which will make the next several weeks very interesting.

As usual, we'll act on evidence from valuations and the quality of market action as it emerges. Regardless of my expectations regarding inflation, the economy or other factors, the prevailing Market Climate holds sway over our investment stance. For now, we remain defensive.

Market Climate

Despite last week's rally on dubious investor hopes that inflation has peaked and is now headed down, what we've actually got is a clearly overbought market in a still unfavorable Market Climate, characterized by unfavorable valuations and still unfavorable market action.

It's not usual for the market to become overbought in unfavorable Market Climates, because rallies typically fail early on. In situations where the market is able to push all the way to a clearly overbought condition, there are two fairly clear possibilities. The first, and most frequent, is a rather abrupt and substantial decline. That's why overbought conditions in hostile Market Climates (and conversely, oversold conditions in favorable Market Climates) are among the only times when I ever have much of an opinion about near-term market action.

That said, the other possibility, that we can't rule out, is that investors are in the process of re-establishing a favorable inclination toward market risk. This outcome is less frequent, because such sponsorship generally emerges right off the bottom, evidenced by things like explosive trading volume, a sustained preponderance of advances versus declines, highs versus lows, uniform industry action, and so forth. Still, the question is “What should we do?” given any possibility that our measures of market action might turn favorable.

The answer is that we wait for that evidence and then act when it arrives. At present, valuations remain elevated (see prior updates as to why I am skeptical of using “forward operating earnings” P/Es over the past decade as a valid benchmark of long-term valuations). So even on an improvement in the quality of market action (which again, is the lesser possibility here), the immediate shift in our market exposure would be only about 10-15% if executed on an advance, and 25-35% if executed on a pullback.

Here and now, given prevailing evidence, our investment stance remains fully hedged in the Strategic Growth Fund.

In bonds, the Market Climate last week was characterized by modestly unfavorable valuations and relatively neutral market action. Bonds have performed well in the past few weeks, but longer-term market action, prevailing evidence on inflation, a lack of widening in credit spreads, and other factors still don't provide enough credible evidence that yield pressures have turned sustainably downward. Here again, it's not out of the question that that evidence could emerge, but at present, we don't have it. As a result, the Strategic Total Return Fund continues to hold a short duration of just under 2 years, mostly in inflation protected Treasury securities, with just under 20% of assets allocated to precious metals shares.

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